Why Stellar Corporate Earnings May Not Boost Stocks

Corporate America's earnings reports should be stellar in the third quarter, fueled by continued economic strength and tax rate reductions combining to produce a 21% year-over-year (YOY) EPS increase for the S&P 500 Index (SPX), Goldman Sachs projects. However, looking ahead to 2019, Goldman sees major risks continuing to grow, especially in the areas of rising tariffs, accelerating wage inflation and interest rate increases.

But the short term is bright. Those S&P 500 sectors expected to see the biggest third quarter profit growth are the energy, financial, materials and tech sectors, as listed in the table below, based on consensus estimates.

A Stellar Third Quarter: Earnings Winners

Sector Estimated 3Q EPS Gain (YOY)
Energy 94%
Financials 39%
Materials 28%
Information Technology 20%
Industrials 19%
Communication Services 18%

Source: Goldman Sachs U.S. Weekly Kickstart Report, Oct. 5.

Significance For Investors

"Recent economic data releases have been extremely strong," Goldman writes, and this is a major driver of sales growth for the S&P 500 companies, which the consensus estimate indicates will be 11% on a YOY basis. Last week, Federal Reserve Board Chair Jerome Powell said that the economic outlook is remarkably positive," Goldman noted. The firm adds these positives: unemployment down to 3.7%, the lowest level in 50 years; the National Federal of Independent Businesses (NFIB) indicates that small business confidence is at the highest level in the 44 years of the NFIB survey; and the Institute For Supply Management (ISM) Non-Manufacturing New Orders Index is at its highest reading since its inception in 1997.

The reduction of corporate tax rates, meanwhile, already contributed 10 percentage points to earnings growth in the first half and will continue to bolster profits. Goldman notes that analysts underestimated the positive impact of tax reform during the first 2 quarters of 2018. Specifically, analysts had estimated that the aggregate effective tax rate for the S&P 500 would be 21% in the first 2 quarters, but it actually turned out to be 19%. As a result, Goldman believes that this could be a source of positive earnings surprises in third quarter results.

Nonetheless, amid all the positive news, Goldman and other market watchers see significant risks ahead. These are summarized in the table below.

Danger Signs: Why Earnings' Glow May Be Short Term

Rising interest rates and bond yields
Higher labor costs
Slowing global economies

Source: Goldman Sachs.

Rising interest rates, accelerating inflation, wage increases and new tariffs are all leading to higher costs of operations for companies, and thus depressing their profit margins. In the previous edition of the same report, dated Sept. 28, Goldman estimated that a 25% tariff on all imports from China would wipe out the entire projected EPS gain for the S&P 500 in 2019. Rather than rising by 6.9%, the EPS growth would remain flat in 2019, Goldman calculates.

Tight labor markets are cited as the top concern by one-third of the respondents to the NFIB small business survey, per Goldman. Higher wages and a lower quality of labor are among the effects that respondents report. These trends also affect larger companies such as those in the S&P 500. Goldman estimates that the net margin for the S&P 500 will rise only marginally between 2018 and 2019, from 11.0% to 11.2%. A bottom-up tally of analysts' estimates, by contrast, implies an increase from 11.5% to 12.0%.

Looking Ahead

Goldman suggests that investors pay close attention to what companies say about those negative trends in their third quarter earnings calls. They previously recommended that investors look to companies with low leverage and low labor costs to protect against rising interest rates and wages. More recently, they suggested that companies with high, stable margins and pricing power are best positioned to ride out an escalating tariff war with China. (For more, see also: 10 High-Margin Stocks To Survive The U.S.-China Trade War.)

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